Optimal annuity risk management

We study the optimal consumption and portfolio choice problem over anindividual’s life-cycle taking into account annuity risk at retirement. Optimally, the investor allocates wealth at retirement to nominal, inflation-linked, and variable annuities and conditions this choice on the state of the economy. We also consider the case in which there are, either for behavioral or institutional reasons, limitations in the types of annuities that are available at retirement.Subsequently, we determine how the investor optimally anticipates annuitization before retirement. We find that (i) using information on term structure variables and risk premia significantly improves the annuity choice, (ii) annuity market incompleteness is economically costly, and (iii) adjustments in the optimalinvestment strategy before retirement induced by the annuity demand due to inflation risk and time-varying risk premia are significant in economic terms.This latter result holds as well for sub-optimal annuity choices. The adjustment to hedge real interest rate risk is negligible.

Netspar, Network for Studies on Pensions, Aging and Retirement, is a thinktank and knowledge network. Netspar is dedicated to promoting a wider understanding of the economic and social implications of pensions, aging and retirement in the Netherlands and Europe.

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